It's almost factual at this point: most 2006 and 2007 buyers of hotel properties will likely default on their mortgages. The reasons are simple: pro forma room rate and occupancy assumptions are being crushed, existing mortgage debt cannot be serviced, and the resulting drop in property values is preventing any kind of loan workout (other than through receivership and foreclosure). The interesting aspect of all this is that some hotel REIT shareholders could actually benefit from this huge mess.

First though, here is a hit parade, if you will, of defaults related to hotels located in "superstar" cities that were previously thought to be impervious to market downturns:

• The St. Regis Monarch Beach hotel, an Orange County luxury resort in Dana Point, has completed a "consensual transfer" of ownership (it was late, and they were drunk) from its owner to its lender, Citigroup.
  


• The Four Seasons Hotel in San Francisco has defaulted on a $90 million mortgage loan.
  


• The Stanford Court Hotel, also in San Francisco, has gone into receivership after defaulting on an $89 million mortgage. JE Roberts bought the place for $93 million in 2007 and then dumped $32 million more into renovations.
  


• Sunstone Hotel Investors chose to make an "elective default" on its the June 1 payment for the $65 million mortgage on the W Hotel in San Diego, which reflected "significant and continuing deterioration in demand for luxury lodging." According to Sunstone's CFO, the value of the W San Diego is "meaningfully below" the what it owes on the property. This is only natural, as they "elected" to overpay in the first place.
  


• According to Commercial Real Estate Direct Sunstone's 366-room Embassy Suites Chicago, is also not generating anywhere near the amount of cash flow needed to service its debt, nor is the 284-room Marriott Del Mar in San Diego, or the 299-room Ontario Airport Marriott.
  


• The 469-room Marriott in downtown L.A., purchased by Ezri Namvar's Namco Capital Group in 207 for approximately $115 million, recently filed for bankruptcy protection.

Luxury hotels in "superstar cities" aside, every day cities are feeling the pinch too. Red Roof Inn Inc., a hotel chain popular with budget-mided business travelers, defaulted on $367 million in mortgage debt earlier this year. Red Roof Inn was acquired for $1.3 billion by a syndicate led by Citigroup's Global Special Situations Unit. It remains unclear whether the unit's mandate is to create special situations, or to invest in them.

Not to be outdone, the Lightstone Group bought Extended Stay Hotels, a chain which operates 680 hotels catering to budget-minded travelers on longer trips, for $8 billion. Lightstone agreed to the purchase in 2007, and financed it at at 92.5% leverage. Unable to service $7.4 billion in debt, the chain promptly filed for Chapter 11 bankruptcy protection 24 months later.

As many as 500 properties could be in default by year's end, according to Atlas Hospitality Group. "The bright spot is that this is going to be the best buying opportunity since the Great Depression," said Alan Reay, the group's principal.

This, perhaps, is what's causing vulture investors to pick at these carcasses. This weekend, REIT Wrecks reader NS alerted me to the Vector Group's (VGR) purchase of over 7% of Strategic Hotels and Resorts's (BEE) common stock. Vector bought the shares for between 96 cents and $1.74 per share in the first and second weeks of July. At this point, despite BEE's hyper-leverage relative to it's underwater NAV, Vector Group and Bill Gates's Cascade Investment Company, another early vulture, now own slightly over 13% of the Company.

Vector is not the only one picking through the rubble. Hong Kong's Keck Seng Investments Ltd. just agreed to buy the San Francisco W Hotel for $90 million. According to The San Francisco Chronicle, although the price represents a 50 percent drop from peak values two years ago. The seller was Starwood Hotels & Resorts, which sold in order to "further reduce its debt levels."

Ironically, Hotel REIT investors could wind up benefiting from these moves, since dumping underperforming properties, even at a loss, will ultimately be accretive to both net asset value and FFO. This may be what is attracting intrepid investors back into the space, but if you choose to play a Hotel REIT recovery, you may need some need patience: Cascade Investments is down about 50% on its initial 2008 investment in BEE (Although BEE is well-managed, it's not worthy of investment in my opinion).




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In just the past two months, 8 Mortgage REITs have filed to raise $3.9 billion in fresh cash, which should not be all that surprising. Retail financial advisors are saying that buckets of high net worth cash are sitting on the sidelines, waiting for opportunities in distressed commercial real estate. With several REIT follow on offerings up 150 percent so far this year, the public market is clearly betting on a turn around. Indeed, back in May, it appeared that the 52 week lows for REITs had already come and gone. Investors are now feeling safe enough to travel even farther down the curve and back into CRE debt, and a slew of new Mortgage REITs are emerging to greet them.

Ladder Capital is the latest aspiring Mortgage REIT, with plans to raise raise $400 million to invest in distressed whole loan mortgages. Ladder Capital Realty Finance (LCRF), as the new firm will be known, will primarily target first mortgage originations as well as senior participations in fixed and floating first mortgage loans.

Regulatory filings indicate that LCRF may also originate and acquire CMBS using TALF money, invest in some B-note and mezzanine loans, as well as provide financing for third party purchases of CRE notes and first mortgages.

Ladder was founded back in October of 2008, when optimism was in even shorter supply than cash. Ladder has already raised $611.6 million from investors, including investments from founding partners TowerBrook Capital Partners, GI Partners and Meridian Capital. The firm has since invested $428 million of that in various deals, including the purchase of Florida's FirstCity Bank of Commerce, which will be renamed Ladder Capital Bank.

In addition to LRCF, Alliance Bernstein, Angelo Gordon, Apollo Global Management, Colony Capital, Starwood Capital and Western Asset Management have all registered to raise equity for their own Mortgage REITs. Invesco's pet Mortgage REIT is already trading, but it had to cut the size of it's offering in half, to $170 million, in order to clear the market. If these new entrants are successful, it will be a strong vindication of the much derided TALF program, and even more evidence that we are not sailing over the cliff into deflation, perennial depression and complete financial oblivion.

The filings make for great reading. Ladder said there is now an “unprecedented market opportunity" to originate well-priced loans. Colony said that the the credit crisis was causing an "over-correction" in commercial real estate debt and that there would be a "protracted opportunity" originate attractive loans. Alliance's new REIT, Foursquare Capital, said that the "current distressed condition in the financial markets" would allow it to buy mortgage assets at "significantly depressed trading prices and higher yields." As for Barry Sternlicht and Starwood, their filings were even more emphatic: "the next five years will be one of the most attractive real estate investment periods in the past 50 years,"

Vornado Realty Trust, much to the chagrin of public shareholders, is raising a $1 billion private real estate fund that will be its "sole vehicle" for investing in distressed office and retail assets in New York and Washington DC. Vornado may have an easier time of it in the public markets: since the start of 2009, 51 REITs have raised more than $16 billion in public equity, according to NAREIT. These numbers tell a compelling story, and there is a lot of "smart" money out there waiting for a bottom that if not already here, soon will be.


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Even with all the capital now chasing distressed commercial real estate, it's still not clear whether these bargains are really much of a bargain. 250 Montgomery St., a downtown San Francisco office building that traded via a distressed note sale is the latest example of the uncertainty. The building, located on San Francisco's "Wall Street of the West", was purchased by Lincoln Properties for $400 a square foot in 2006, but it just sold in a deed-in-lieu-of-foreclosure for $172 a square foot.

Clearly, this is a huge decline in price, and even the senior lender, Realty Finance Corp, took a $22 million hit. It was also the first San Francisco office building to trade in a year, and the first “round trip” sale, where a property goes from a one new owner directly to another new owner via a deed in lieu of foreclosure. The total sale price of $19.9 million represents about 25% of replacement cost.

From that standpoint, the buyer got a fantastic deal. But a broker familiar with the sale said the building actually traded about 40% ABOVE his initial BOV and also attracted three times as many bidders as a traditional fee-simple sale would have seen. The broker said they are advising all of their lender clients to do note sales to the high level of interest in properties marketed as "distressed assets."

Part of the reason for the lower opinion of value was rent growth, or the lack of it. The broker, who has been selling instutional office property for the better part of 20 years, doesn't see any. In fact, he is reducing typical rent rolls by 20%, and then assuming no growth for 5 years.

Who was the buyer? It was Argonaut Capital, a Tulsa-based private equity firm controlled by just one investor, billionaire George Kaiser, who was nowhere on the commercial real estate radar until this purchase. Argonaut is neither a distressed asset neophyte nor a stranger to alternative assets (one of its most recent purchases was $412 million in natural gas assets from Chesapeake Energy), but real estate doesn't appear to be a major area of focus for the firm.

Surely 25% of replacement cost for an office building in downtown San Francisco can't be all bad, but given the fundamentals, it may be quite some time before any new money is pulled out of this deal. Nevertheless, if you're a billionaire with plenty of cash and other interesting things to do in the meantime, who cares? These are the kinds of buyers now swimming in the distressed asset pool, and with approximately 30 of them all clamoring a piece of San Francisco dirt with no clear value, it's practically deja vu all over again.

While John Mauldin may read "hundreds of articles, reports, books and newsletters" in order to bring you the one essay each week that will "stimulate your thinking", he will also roll for commissions, and that's pretty much all you need to know about his weekly email. More on that later, but first, what about his most recent electronic dirge, in which his illustrious guest scribe heaped upon us innocents the same lost decade of deflation and despair that befell Japan in the wake of its banking crisis?

Presumably, those who choose to heed the call of Mauldin's high-end affiliate marketing scheme shall be saved from this particular despair, but there's really no need to bother. My colleagues and I spend an awful lot of time thinking about the risks of deflation and inflation relative to commercial real estate investments (ironically, REIT Wrecks also spent the weekend at an undisclosed location with an official from the Treasury Dept., and we happened to talk about this very same issue), and in our carefully considered, pretty much conflict-free opinions, Mauldin's lost decade deflation scare is nothing but a bunch of self-serving, poorly researched crap.

REIT Wrecks is far from achieving Mauldin-like internet nobility, but I'm also not an Introducing Broker. I have actual dirt underneath my fingernails, and a decided lack of sycophantic staff willing to manicure them on a daily basis. However, since I must still add, multiply, divide and subtract on my own, I have decided to use this golden opportunity shooting ducks in a barrel!! to show you, my REIT crazy comrades, why the Mauldins of the world are not to be entirely trusted.

Mauldin's guest "analyst" in last Friday's email was a glorified stock broker named Niels Jensen. He runs a firm called Absolute Return Partners, and he is probably a really nice guy. It's an innocuous compliment and also Wall Street code for not being all that bright. Indeed, the first time I heard that expression used in this manner was when he and I shared the same employer some years ago, and sadly it's the best I can do given the quality of his "analysis". To conclude otherwise would be to claim that his analysis is intentionally misleading...and I will leave that dirty bit up to you.

So what about Jensen's claim that we face the same lost decade as Japan? Is there anything to it? On the surface, the parallels are alarming. It's true, the Japanese did experience a banking crisis, and they learned that "recovering from a deflated credit bubble is a long and very painful affair." Redundantly, barely one paragraph and a colorful but mostly irrelevant chart later, he goes on to write:

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

Finally, after more gee-whiz gobbledy-gook on such esoterica as the output gap and inelastic commodity demand, he concludes that "the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere."

Wow! All those pretty charts and this is the best he can do? Clearly, REIT Wrecks suffers from a chart deficiency, and anyone who can send me some pretty new ones will get a free subscription to Mauldin's newsletter. In the meantime, as usual, I have made my own.

Now, with respect to Japan being "nowhere", there is actually good reason for that, and while the charts below are in fact hand crafted by yours truly, I must credit Foreign Affairs for publishing - barely two months ago - a convenient and timely article on the the "Japan Fallacy", as they refer to it (Volume: 88, Issue: 2, March/April 2009). Evidently, Jensen was too busy churning client accounts to bother reading it, and somehow Foreign Affairs isn't anywhere on Mauldin's radar.

That aside, while it is true that Japan suffered a banking crisis in the early 1990s, and that in response the Japanese government pursued strategies similar to those now being employed by the U.S. Treasury and Federal Reserve, the similarities end abruptly there. Any further comparisons to Japan then and the crisis in United States now are just not accurate.

The reason is that Japan's banking crisis was dramatically different from ours, and for reasons known only to him, Jensen spends no time evaluating those differences. Fundamentally, the crisis in the U.S. was caused by narrow dysfunction in our financial sector, and that caused an economic crisis. In Japan, the problem was pervasive dysfunction in the entire economy:

Japan's malaise was woven into the very fabric of its political economy...weak domestic firms and industries were sheltered from competition by a host of regulations and collusion among companies. Ultimately, that system limited productivity and potential growth. The problem was compounded by built-in economic anorexia. Personal consumption lagged, not because people refused to spend, but because the same structural flaws caused real household income to keep falling as a share of real GDP. To make up for the shortfall in demand, the government used low interest rates as a steroid to pump up business investment. The result was a mountain of money-losing capital stock and bad debt.

The Japan Fallacy: Today's U.S. Financial Crisis is Not Tokyo's Lost Decade. Foreign Affairs, March/April 2009.

The Japanese and U.S. crises differ in numerous other ways, but one of the starkest contrasts is in the response of policymakers. Denial, dithering, and delay were the hallmarks in Tokyo. Jensen doesn't bother to mention that it took the Bank of Japan nearly nine years to bring the overnight interest rate from its 1991 peak of eight percent down to zero. The U.S. Federal Reserve did that within 16 months of declaring a financial emergency, which it did in August 2007. It has also applied all sorts of unconventional measures to keep credit from drying up.

Furthermore, Jensen fails to mention that Tokyo lacked the political will to allow widespread bank failures. The collapse of Lehman Brothers remains the largest corporate bankruptcy ever in the United States, but nothing like it was ever allowed to happen in Japan.

On the contrary, Tokyo used government money to help its banks keep lending to insolvent borrowers and protect their shareholders. The result was a country that became even more deeply indebted, supported by an economy that was not productive enough to pay it all off. Consequently, Japan’s public debt, already the world’s largest (second only to Zimbabwe!), will surge to 197 percent of gross domestic product in 2010, according to the OECD:


The United States, over there near its more quiet neighbor, Canada, is not even close. What about the massive $787 billion fiscal stimulus just signed into law, will that squeeze the U.S. into a cell next to Japan in debtor's prison? It's unlikely. The reason is that the Japanese economy is much smaller than the U.S. economy, and unlike the U.S., Japan's population is contracting. On average, Japan's population is also much older. As a result, Japan is much less productive than the U.S., and even though U.S. government debt is forecast to swell to about 70% of GDP through 2014, that would still be less than half that of Japan today, and far below that which was incurred by the U.S. during World War II:

Note: This graph represents the cumulative total of all government borrowings in U.S. dollars, less repayments. It does not include liabilities related to funds held in trust (like Social Security) or financial assets (like agency securities). "Debt Held by the Public" is not "external debt", which reflects the foreign currency liabilities of both the private and public sector.


Ironically, Jensen does note that most observers condemned the Japanese approach as hopelessly inadequate, which it was, but he also implies that it was identical to what was employed by the U.S., which it wasn't. Is this the kind of work they do over at Absolute Return Partners? If so, why would Mauldin be so devilishly fond of them??

Policy mistakes -- from Japan's mismanaged fiscal and monetary policy to the government's failure to address the loan crisis -- made a bad situation even worse. But even if policymakers had done everything right, Japan's economy still would have stagnated until Tokyo addressed its more fundamental flaws.

A far better comparison might have been the Asian financial crisis, which proved that once financial markets are calmed and policy mistakes are reversed, economies recover. Even clumsy Russia managed to recover from its 1998 financial crisis and currency devaluation. Apparently, neither of these two examples suited Jensen's needs.

As for the hopelessly conflicted Mauldin, what's black and white and read all over? Unfortunately, it's not a newspaper, as nobody reads them anymore. It's the disclaimer in small print located at the bottom of Mauldin's "E-letter", conveniently overlooked by most, and which I have edited slightly for clarity:

Mauldin cooperates in the marketing of private investment offerings with Absolute Return Partners. Funds recommended by Mauldin may pay a portion of their fees to Absolute Return Partners, who will share 1/3 of those fees with Mauldin. Mauldin only recommends products with which he has been able to negotiate fee arrangements.

In other words, Mauldin will treat his loyal readers to the worst ideas from any old crap fund, so long as the fund managers can afford to pay him off for the favor. In Brooklyn, they might call this racketeering, were they not so stupefied as to how it's all completely legal. My advice? Just go read Foreign Affairs.

JP Morgan analyst Anthony Paolone is understandably not bullish on commercial real estate fundamentals, but since the public market is typically ahead of the private market in terms of valuations, he does like certain REITs.

Brandwine in particular has both refinanced existing debt, and repurchased its own debt on the open market (for a quick explanation of the accounting behind debt repurchases, read Muddled REIT Book Values Create Opportunity). The ability to delever in this market is obviously muy bueno, even though Brandywine also diluted shareholders to death in the process.

Paolone also thinks (BDN) will pay a special dividend in Q4. Be aware of the fact that JP Morgan was joint lead underwriter on BDN's very dilutive equity offering, so do look carefully beneath the hood before plunging in.

Enjoy the vid!

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One major reason for investing in commercial real estate and REITs is that real estate is thought of as an effective hedge against inflation, yet commercial properties were an abyssmal inflation hedge in the early 1990s. So why are they still considered to be an inflation hedge if that isn't always the case? As usual, it's mostly about timing and location. (Note: For the time being, I am ignoring the actual likelihood of inflation or deflation - more on deflation here; more on inflation to follow. You may also be interested in a recent Brookings Institute report on recession proof real estate)

As this NAREIT chart conveniently shows, equity REITs (in green) declined in the early 1990s (circled in blue), even though the Gulf War and high oil prices were driving commodity prices (in black) higher:


Even more conveniently, this NAREIT chart, with inflation added in via the CPI, shows that REITs were actually highly correlated to the S&P 500 (i.e. stocks!), and that both performed horribly during the early 1990s:




These NAREIT charts help illustrate that the market value of all types of commercial properties actually collapsed after about 1989, even though the CPI and commodities rose. So why did this happen? The lesson from the early 1990s is that in the short run, private real estate equity and public real estate equities are not effective hedges against inflation if there is a large overhang of supply. Indeed, this video on retail big box vacancies in Orange, CT shows that one result of oversupply is high vacancy rates:




For those of you who prefer more excruciating detail, this study by Wurtzebach, Mueller and Machi (circa 1991) takes an academic approach to explain what may already be intuitive to those of you that own and operate commercial real estate: real estate is an effective hedge against inflation only if the markets are in balance. If the markets get out of balance (defined as vacancy rates above 10%), high vacancy rates make it impossible to raise rents to combat inflation:




According to Wurtzebach, et al., imbalances are especially pronounced after periods of capital markets excess, such as the one we just experienced. No property sector is totally immune to the current imbalance, but retail real estate in particular faces a lot of pressure given bankruptcies at GM, Chrysler, Circuit City, Mervyns, Steve & Barry's, Linen's 'N Things, etc.

In the auto industry alone, 881 car dealerships were closed in 2008, and GM and Chrysler have announced closings of over 2,000 more in 2009. Skyrocketing vacancy rates mean that the vast majority of these sites will languish and sit empty for several years, nevermind generate any income or appreciate in value.

REITs and commercial real estate can be an effective inflation hedge if you have a longer-term investment horizon, or if you invest specifically in REITs that own quality assets in protected markets that provide pricing power (Federal Realty Trust (FRT) being a good example). But not all investors have the luxury of the buy-and-hold approach, and if you're hoping that inflation will be the panacea for a poorly-timed asset purchase in a weak market (e.g., Phoenix, Las Vegas, Tampa), it's definitely time to implement Plan B.

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